Fridson: Junk Bonds ‘Extremely Overvalued,’ Triple-Cs Least Rich

By Michael Aneiro

Junk-bond market veteran Martin Fridson has offered a response to my latest Current Yield column, in which several unconstrained bond-fund managers say they’ve cut back on junk bonds lately, while one says the asset class is still the best value in an overbought bond market. In a typically deeply researched note, Fridson – now chief investment officer at Lehmann, Livian, Fridson LLC – subjects the current arguments for and against junk bonds to some rigorous statistical analysis regarding Treasury yields and junk-bond spreads and excess returns. In a nutshell, Fridson takes issue with fund managers’ reliance on historical comparisons of junk-bond risk premiums. Here’s Fridson, writing for Standard & Poor’s Leveraged Commentary & Data:

While their conclusions differ, they all compare the high-yield spread – however they calculate it – to the spread on some historical date or in some historical period. Such comparisons are, in our view, irrelevant. The spread is a risk premium. What matters, it seems to us, is whether the risk premium is in line with the risk. If investors are receiving too small a risk premium for the prevailing risk, high-yield is rich. If investors are receiving too large a risk premium for the prevailing risk, high-yield is cheap.

Fridson’s verdict? Using his own model for gauging junk-bond risk, he sees “extreme overvaluation” in today’s high-yield market:

[T]he bad news is that high-yield is extremely overvalued, i.e., by more than one standard deviation. Investors can take some consolation from the fact that the asset class is not as overvalued as it was a month ago….

[O]ur analysis does not support the view that there is no better place for bond investors to be than in high-yield. From an expected-return viewpoint, the five-year Treasury is a superior holding. Note, however, that expected return is an average over many observations. In any given instance, including the present one, high-yield might outperform. In particular, the Fed could artificially preserve investors’ preference for risky assets throughout the next 12 months. In short, policy could trump fundamentals.

Based on his calculations, Fridson says says the lowest-tier triple-C rated junk bonds offer the best value within that overvalued high-yield market:

The CCC/CC/C group is currently the least overvalued, with the “pure CCC” category group representing the next best choice. The single-B category’s worst-place finish likely reflects a stretch for yield that is mitigated by institutional investor guidelines that limit exposure to bonds rated below B-.